Debt Contraction Means Fewer Bankruptcy Filings, Chargeoffs

Credit card chargeoffs have been plunging since the middle of last year, moving against the tide of an anemic jobs environment but supported by slowing bankruptcies.

However, the favorable bankruptcy trend may itself simply be part of the broader phenomenon of the burn-off of bad loans that has allowed loss rates to improve despite high unemployment and, recently, a reversal in the downward trend in initial jobless claims (see charts).

Chargeoffs of marginal accounts and tighter underwriting have isolated weaker borrowers from the credit pool, and less consumer credit means less debt to discharge in bankruptcy.

Now, consumer credit has just begun to post year-over-year growth again, and the slack may be buying struggling households extra time, helping to sustain the decline in bankruptcy filings, at least for a while.

"People can finance current consumption on their credit card and other borrowing" and avoid seeking bankruptcy protection, said Robert Lawless, a professor at the University of Illinois College of Law who specializes in consumer credit issues. "What drives people into bankruptcy court is they run out of options."

"You can become no more bankrupt," he added. "If you're insolvent, you're insolvent, and if someone will continue lending to you, you might as well continue borrowing in the hopes that things will turn around."

Monthly bankruptcy filing rates were posting year-over-year growth of more than 35% in early 2009, according to data from Epiq Systems Inc.

Lawless attributes some of that pace to the lingering effects of major revisions to bankruptcy law that went into effect in late 2005 and made it harder for people to shed debt. The change accelerated filings that would have been made after the new rules, and established a low benchmark from which filings increased.

But Lawless' research has found that the primary influence on bankruptcy filings over the long term is simply the level of consumer credit. "It's almost a mechanical relationship," he said.

The year-over-year change in consumer credit became negative in early 2009, according to data from the Federal Reserve, and the pace of filings followed suit in late 2010. (Despite the downtrend, the average 5,500 filings per filing day in June were still at about the same level as in February 2009.)

Consumer credit started to grow year over year in April (though revolving credit — mostly credit cards — has yet to break into positive territory). While the loosening may be helping to extend the decline in bankruptcy filings for now, history suggests that ultimately its effect will be the opposite.